Managerial Accounting Standard Costing

1. Chapter 9
Standard Costing

2. TABLE OF CONTENTS
• Summary
• Understand the concept of Standard costing

3. SUMMARY

4. SUMMARY
• Standard costing is an important subtopic of cost accounting.
Standard costs are usually associated with a manufacturing
company's costs of direct material, direct labor, and
manufacturing overhead.
• Rather than assigning the actual costs of direct material, direct
labor, and manufacturing overhead to a product, many
manufacturers assign the expected or standard cost. This
means that a manufacturer's inventories and cost of goods
sold will begin with amounts reflecting the standard costs, not
the actual costs, of a product. Manufacturers, of course, still
have to pay the actual costs. As a result there are almost
always differences between the actual costs and the standard
costs, and those differences are known as variances.

5. SUMMARY
• Standard costing and the related variances is a valuable
management tool. If a variance arises, management becomes
aware that manufacturing costs have differed from the
standard (planned, expected) costs.
• If actual costs are greater than standard costs the variance is
unfavorable. An unfavorable variance tells management that if
everything else stays constant the company's actual profit will
be less than planned.
• If actual costs are less than standard costs the variance is
favorable. A favorable variance tells management that if
everything else stays constant the actual profit will likely
exceed the planned profit.

6. STANDARD COSTING
Section 1

7. STANDARD COSTING
• Standard costing is a key element of performance
management with a particular emphasis on budgeting and
variance analysis.

8. THE USES OF STANDARD COSTS
The main purposes of standard costs are:
• Control: the standard cost can be
compared to the actual costs and any
differences investigated.
• Performance measurement: any
differences between the standard and
the actual cost can be used as a basis for
assessing the performance of cost
centre managers.
• Variances: as well as being the basis for
preparing budgets, standard costs are
also essential for calculating and
analysing variances. Variances provide
'feedback' to management indicating
how well, or otherwise, the company is
doing.
• To value inventories: an alternative to
methods such as LIFO and FIFO.
• To simplify accounting: there is only
one cost, the standard
Control
Performance
measurement
Variances
To value
inventories
To simplify
accounting

9. FOUR TYPES OF STANDARD
Attainable standards
• They are based upon efficient (but
not perfect) operating conditions.
• The standard will include allowances
for normal material losses, realistic
allowances for fatigue, machine
breakdowns, etc.
• These are the most frequently
encountered type of standard.
• These standards may motivate
employees to work harder since they
provide a realistic but challenging
target.
Attainable standards
Basic standards
Current standards
Ideal standards

10. FOUR TYPES OF STANDARD
Basic standards
• These are long-term standards which
remain unchanged over a period of
years.
• Their sole use is to show trends over
time for such items as material prices,
labour rates and efficiency and the
effect of changing methods.
• They cannot be used to highlight
current efficiency.
• These standards may demotivate
employees if, over time, they become
too easy to achieve and, as a result,
employees may feel bored and
unchallenged.
Attainable standards
Basic standards
Current standards
Ideal standards

11. FOUR TYPES OF STANDARD
Current standards
• These are standards based on current
working conditions.
• They are useful when current
conditions are abnormal and any
other standard would provide
meaningless information.
• The disadvantage is that they do not
attempt to motivate employees to
improve upon current working
conditions and, as a result,
employees may feel unchallenged.
Attainable standards
Basic standards
Current standards
Ideal standards

12. FOUR TYPES OF STANDARD
Ideal standards
• These are based upon perfect
operating conditions.
• This means that there is no wastage
or scrap, no breakdowns, no
stoppages or idle time; in short, no
inefficiencies.
• In their search for perfect quality,
Japanese companies use ideal
standards for pinpointing areas
where close examination may result
in large cost savings.
• Ideal standards may have an adverse
motivational impact since employees
may feel that the standard is
impossible to achieve.
Attainable standards
Basic standards
Current standards
Ideal standards

13. MANAGEMENT CONTROL, VARIANCE ANALYSIS
AND 'MANAGEMENT BY EXCEPTION'
A key principle of management
control is that of 'management by
exception'. This involves the
following steps:
• Set the standard cost for the
period.
• Record actual results.
• Compare the actual cost with
what should have happened. The
difference is called a "variance".
• Investigate significant variances -
this allows management to focus
only on those areas where the
business is not performing
according to the plan, thus
making management effort more
efficient.
Set the standard
cost
Record actual
results.
Compare the
actual cost
Investigate
significant
variances

14. REVISING STANDARDS TO CALCULATE
PLANNING AND OPERATING VARIANCES
• Some businesses revise standards and
calculate what are known as "planning and
operating" variances.
• There must be a good reason for deciding that
the original standard cost is unrealistic.
Deciding in retrospect that expected costs
should be different from the standard should
not be an arbitrary decision, aimed perhaps at
shifting the blame for bad results due to poor
operational management or poor cost
estimation.
A good reason for a change in the standard might
be:
• a change in one of the main materials used to
make a product or provide a service
• an unexpected increase in the price of
materials due to a rapid increase in world
market prices (e.g. the price of oil or other
commodities)
• a change in working methods and procedures
that alters the expected direct labour time for
a product or service
• an unexpected change in the rate of pay to
the workforce.
A change in one of the
main materials
An unexpected increase
in the price
A change in working
methods
an unexpected change
in the workforce rate of
pay

15. REVISING STANDARDS TO CALCULATE
PLANNING AND OPERATING VARIANCES
• These types of situations do not
occur frequently. The need to
report planning and operational
variances should therefore be an
occasional, rather than a regular,
event.
• If the budget is revised on a
regular basis, the reasons for this
should be investigated. It may be
due to management attempting
to shift the blame for poor
results or due to a poor planning
process.
Illustration
A company is operating in a fast
changing environment and is
considering whether analysing
existing variances into a planning
and operational element would
help to improve performance.
Discuss the advantages and
disadvantages of the approach.

16. REVISING STANDARDS TO CALCULATE
PLANNING AND OPERATING VARIANCES
Solution
Advantages may include:
• Variances are more relevant, especially in
a turbulent environment.
• The operational variances give a 'fair'
reflection of the actual results achieved in
the actual conditions that existed.
• Managers are, theoretically, more likely to
accept and be motivated by the variances
reported which provide a better measure
of their performance.
• The analysis helps in the standard-setting
learning process , which will hopefully
result in more useful standards in the
future.
Variances are more relevant
The operational variances
give a 'fair' reflection
Managers accept and be
motivated by the variances
reported
The analysis helps in the
standard-setting learning process

17. REVISING STANDARDS TO CALCULATE
PLANNING AND OPERATING VARIANCES
Disadvantages:
• The establishment of ex-post budgets is
very difficult. Managers whose
performance is reported to be poor using
such a budget are unlikely to accept them
as performance measures because of the
subjectivity in setting such budgets.
• There is a considerable amount of
administrative work involved first to
analyse the traditional variances and then
to decide on which are controllable and
which are uncontrollable.
• The analysis tends to exaggerate the
interrelationship of variances, providing
managers with a 'pre-packed' list of
excuses for below standard performance.
Poor performance is often excused as
being the fault of a badly set budget.
• Frequent demands for budget revisions
may result in bias.
Establishment of ex-post budgets
is very difficult
A considerable amount of
administrative work
The analysis exaggerates
the interrelationship of
variances
Frequent demands for budget
revisions

18. THE SUITABILITY OF STANDARD COSTING IN
DIFFERENT ORGANISATIONS
Standard costing is most suited to
organisations with:
• Mass production of homogenous
products
• Repetitive assembly work
• The large scale repetition of
production allows the average
usage of resources to be
determined.
• Standard costing is less suited to
organisations that produce non-
homogenous products or where
the level of human intervention
is high.
Mass production
of homogenous
products
Repetitive
assembly work

19. THE SUITABILITY OF STANDARD COSTING IN
DIFFERENT ORGANISATIONS
Example: McDonalds
Restaurants traditionally found it difficult to
apply standard costing because each dish is
slightly different to the last and there is a high
level of human intervention.
McDonalds attempted to overcome these
problems by:
• Making each type of product produced
identical. For example, each Big Mac
contains a pre-measured amount of sauce
and two gherkins. This is the standard in
all restaurants.
• Reducing the amount of human
intervention. For example, staff do not
pour the drinks themselves but use
machines which dispense the same
volume of drink each time.
McD
Standard
costing
Pre-measured
sauce for Big Mac
Produced
identical
products
Drink machine
dispenser

20. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Variance analysis may not be
appropriate because:
Non-standard products
• Standard product costs apply to
manufacturing environments in
which quantities of an identical
product are output from the
production process. They are not
suitable for manufacturing
environments where products
are non-standard or are
customised to customer
specifications.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

21. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Standard costs become outdated
quickly
• Shorter product life cycles in the
modern business environment
mean that standard costs will
need to be reviewed and
updated frequently.This will
increase the cost of operating a
standard cost system but, if the
standards are not updated
regularly, they will be of limited
use for planning and control
purposes. The extra work
involved in maintaining up-to-
date standards might limit the
usefulness and relevance of a
standard costing system.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

22. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Production is highly automated
• It is doubtful whether standard
costing is of much value for
performance setting and control
in automated manufacturing
environment. There is an
underlying assumption in
standard costing that control can
be exercised by concentrating on
the efficiency of the workforce.
Direct labour efficiency standards
are seen as a key to management
control.However, in practice,
where manufacturing systems
are highly automated,the rates of
production output and materials
consumption, are controlled by
the machinery rather than the
workforce.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

23. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Ideal standard used
• Variances are the difference
between actual performance and
standard, measured in cost
terms. The significance of
variances for management
control purposes depends on the
type of standard cost used. JIT
(Just in time) and TQM (Total
quality management) businesses
often implement an ideal
standard due to the emphasis on
continuous improvement and
high quality. Therefore, adverse
variances with an ideal standard
have a different meaning from
adverse variances calculated with
a current standard.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

24. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Emphasis on continuous
improvement
• Standard costing and
adherence to a preset
standard is inconsistent with
the concept of continuous
improvement, which is
applied within TQM and JIT
environments.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

25. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Detailed information is
required
Variance analysis is often
carried out on an aggregate
basis (total material usage
variance, total labour efficiency
variance and so on) but in a
complex and constantly
changing business environment
more detailed information is
required for effective
management control.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

26. STANDARD COSTING AND VARIANCE ANALYSIS
IN THE MODERN MANUFACTURING
ENVIRONMENT
Monitoring performance is
important
• Variance analysis control
reports tend to be made
available to managers at the
end of a reporting period. In
the modern business
environment managers need
more 'real time' information
about events as they occur.
Non-standard products
Standard costs outdated quickly
Production is highly automated
Ideal standard used
Continuous improvement
Detailed information is required
Monitoring performance is important

27. STANDARD COSTS AND BEHAVIORAL ISSUES
Standard costs are set with a view to
measuring actual performance against the
standard, and reporting variances to the
managers responsible. The aims of setting
standards include:
• setting a target for performance
• motivating the managers responsible
to achieve those targets
• holding these managers accountable for
actual performance
• perhaps rewarding managers for good
performance and criticizing them for
poor performance.
• Managers and employees might
respond in different ways to standard
setting.
A target for
performance
Motivating the
managers
responsibilities
Managers
accountable for
actual
performance
Rewarding and
criticizing the
manager
Respond in
different ways to
standard setting.

28. THE TYPE OF STANDARD SET
Individuals might respond to standards in
different ways, according to the difficulty
of achieving the standard level of
performance.
• Ideal standard: When a standard level
of performance is high, e.g. an ideal
standard, employees and their
managers will recognise that they
cannot achieve it. Since the target is not
achievable, they might not even try to
get near it.
• Current standard: When the standard of
performance is not challenging (e.g. a
current standard), employees and their
managers might be content simply to
achieve the standard without trying to
improve their performance.
• Attainable standard: An attainable
standard might be
Ideal standard
Current
standard
Attainable
standard
Basic standard

29. THE TYPE OF STANDARD SET
• Attainable standard: An attainable
standard might be set which challenges
employees and their managers to
improve their performance. If this
attainable standard is realistic, it might
provide a target that they try to achieve.
Some employees will be motivated by
this challenge and will work harder to
achieve it. However, some employees
may prefer standards to be set at a low
level of performance, in order to avoid
the need to work harder.
• Basic standard: This type of standard
may motivate employees since it gives
them a long-term target to aim for.
However, the standard may become out
of date quickly and, as result, may
actually demotivate employees.
Ideal standard
Current
standard
Attainable
standard
Basic standard

30. THE LEVEL OF PARTICIPATION IN STANDARD SETTING

31. THEUSEOFPAYAS AMOTIVATOR
• If standards are used as a way of
encouraging employees to
improve their performance,
motivation could be provided in
the form of higher pay if targets
are reached or exceeded.
• However, if employees are
offered a bonus for achieving
standard costs, this could
increase their incentive to set
low standards of performance,
i.e. include 'slack' in the standard
cost. Lower standards will
increase the probability that the
standards will be achieved and a
bonus will be earned.
Motivation
Performance
Slack